Can a country have a balance of trade surplus and a balance of payments deficit?

Summary

1.

The balance of payments records a country’s international transactions: payments and receipts that cross the country’s border.

The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry.

If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists.

The current account is the sum of the merchandise, services, primary income, and secondary income accounts.

Current account deficits are offset by financial account surpluses.

The balance of trade is the merchandise exports minus the merchandise imports.

The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions.

An increase (decrease) in US-owned deposits in foreign banks is a debit (credit) to the US financial account. While an increase (decrease) in foreign-owned deposits in US banks is a credit (debit) to the US financial account.

The United States became a net international debtor in 1986.

Deficits are not necessarily bad, nor are surpluses necessarily good.

With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changes.

With fixed exchange rates, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium.

Balance of Payments Model

The balance of payments model postulates that a foreign exchange rate in equilibrium will remain in equilibrium, providing it maintains a stable account balance. The model is based on the expectation that foreign exchange rates are completely determined by the trade deficit (exports—imports).

A country with a trade deficit (e.g., the country is importing more goods than it is exporting) will experience a devaluation of its foreign exchange rate. A country with a trade surplus (e.g., the country is exporting more goods than it is importing) will experience a strengthening of its foreign exchange rate. When the country experiences a trade deficit, it also experiences a decrease in its foreign reserves. This results in a lower currency value making its goods, services, and products less expensive, which is likely to stimulate foreign purchases and exports and reduce imports because the foreign goods have become more expensive. In theory, this is expected to then balance the trade deficit and bring currency rates back to equilibrium. When the country experiences a trade surplus, it also experiences an increase in its foreign reserves. This results in a higher currency value, making its goods, services, and products more expensive, which is likely to reduce foreign demand due to higher prices, but will also stimulate imports since the foreign prices are now lower. In theory, this is expected to then balance the trade deficit and bring currency rates back to equilibrium.

The balance of payments model is similar to Purchasing Power Parity in that it focuses solely on goods, services, and commodities that are tradeable. It does not consider the effect of capital flows and financial assets (e.g., stocks and bonds) on the foreign exchange rates. These factors are considered in the asset market model.

The BP Curve

The final curve portrayed in Fig. 13.1 is the BP curve. The BP curve gives the combinations of i and Y that yield balance of payments equilibrium. The BP curve is drawn for a given domestic price level, a given exchange rate, and a given net foreign debt. Equilibrium occurs when the current account surplus is equal to the capital account deficit. Recall from Chapter 3, The Balance of Payments that if there is a current account deficit, then it has to be financed by a capital account surplus.

Fig. 13.4 illustrates the derivation of the BP curve. The lower panel of the figure shows a CS line, representing the current account surplus, and a CD line, representing the capital account deficit. Realistically, the current account surplus may be negative, which would indicate a deficit. Similarly, the capital account deficit may be negative, indicating a surplus. The CS line is downward sloping because as income increases, domestic imports increase and the current account surplus falls. The capital account is assumed to be a function of the interest rate and is, therefore, independent of income and a horizontal line.

Equilibrium occurs when the current account surplus equals the capital account deficit, so that the official settlements balance of payments is zero. Initially, equilibrium occurs at point A with income level YA and interest rate iA. If the interest rate increases, then domestic financial assets are more attractive to foreign buyers and the capital account deficit falls to CD′. At the old income level YA, the current account surplus will exceed the capital account deficit, and income must increase to YB to provide a new equilibrium at point B. Points A and B on the BP curve in Fig. 13.4 illustrate that, as i increases, Y must also increase to maintain equilibrium. Only an upward sloping BP curve will provide combinations of i and Y consistent with equilibrium.

In deriving the BP curve, we assumed that higher interest rates in the domestic economy would attract foreign investors and decrease the capital account deficit. If capital is perfectly mobile for any income level, then any deviation of the domestic interest rate from the foreign rate would cause investors to attempt to hold only the high return assets. Therefore, the BP curve becomes perfectly horizontal in the case of perfectly mobile capital. If foreign capital is not perfectly available then the BP curve will be upward sloping. If there are many restrictions to capital mobility then the BP curve will become close to vertical. Fig. 13.5 illustrates a perfectly horizontal BP curve and an upward sloping BP curve.

It is also important to realize that the BP curve can shift whether it is upward sloping or horizontal. For example, a changing foreign perception of the substitutability shifts the BP curve. This is an intercept change, and thus the entire schedule shifts. For example, in Fig. 13.6 one can see how an increase in the perception of riskiness of a country’s assets causes the BP curve to shift upward. Thus, interest rates are not equal across countries even with perfect capital mobility. For example, Indonesia may have a positive risk premium, so that investors demand a certain added premium for financing Indonesia’s trade deficits. However, as long as that particular risk premium is paid, investors are willing to finance the trade deficit.

The financing process

The process of providing IMF financing begins when a member country, facing balance of payments difficulties, requests ‘an arrangement.’ The country, working in close cooperation with Fund staff, designs a program that includes a request for funds and conditions that the member country commits to meet in order to remedy its macroeconomic problems. The request is contained in a Letter of Intent, which usually has a Memorandum of Economic and Financial Policy attached that sets out, with a timetable, the steps that the country judges will resolve its balance of payments problem, restore its macroeconomic stability, and safeguard Fund resources (i.e., enable it to repay the Fund). After the Executive Board approves the arrangement, the first tranche is disbursed. Disbursement of subsequent tranches is contingent on the observance of the performance criteria and other types of conditionality that are contained in the Letter of Intent and sometimes a Side Letter. Program reviews assess whether performance criteria and indicative targets (on money and credit aggregates, international reserves, fiscal balances, and external borrowing) have been met and whether performances under structural benchmarks (targets for financial sectors reform, social safety nets, and public debt management) are on track.11 Waivers may be granted on missed targets and program modifications may be made to keep the program moving forward.

The financing process for the Fund's emergency assistance facilities (SLF, ENDA, EPCA, Compensatory Financing Facility, and RCF) is different, however, in that it involves ‘outright purchases’ rather than arrangements; that is, its conditionality is ex ante as well as ex post.

Economic Development and Reform

Early development theory emphasized ‘macroeconomic accounting aggregates such as savings and the balance of payments, and the relative balance between broadly defined “sectors” such as “industry” and “agriculture”‘ (Lal, 1983, p. 5). When that prescription proved disappointing, the pendulum swung in the opposite direction. The new imperative was to activate the market and ‘get the prices right’ (Lal, 1983, p. 107), but that too was overly simple.

‘Getting the property rights right’ seemed more responsive to the pressing needs for reform in Eastern Europe and the former Soviet Union. But while ‘an essential part of development policy is the creation of polities that will create and enforce efficient property rights, … we know very little about how to create such polities’ (North, 1994, p. 366). As discussed in Section Russian privatization, privatization is important but is not a panacea.

Data Collection and Reliability

The key source for contemporary data on measuring international remittances is the International Monetary Fund's Balance of Payments Statistics Yearbook. While the IMF aspires to standardize the way these data are compiled by individual governments the reality is that data coverage at the present time is inconsistent and the figures for remittances that are widely circulated by agencies, academics, and journalists have to be treated with some caution. Furthermore, while these data enable analysts to make reasonable estimates of the volume of remittances coming into countries, they are much less accurate when trying to calculate remittances going out of countries. The general assumption is that current figures underestimate total remittances not only because they fail to include informal capital movements (such as hand carries of cash and some hawala transfers) but also because some remittances (such as jewelry) are recorded in the statistics as imports. The World Bank provides an annual update on global remittance flows, which is a crucial resource for mapping trends.

Balance of Payment Effects

The drastic changes in the price of oil in the 1970s had major financial and balance-of-payments repercussions on the oil importing countries. Total energy imports as a percent of total merchandise exports in 1960 had amounted to less than 11 percent worldwide. In 1977, energy import costs had increased to between 16 and 40 percent of exports for the low-income, non-oil producing countries; to 24 percent for the middle-income countries; and to 20 percent for the industrialized countries. However, these average percentages hide rates of dependency that are much higher for a number of individual countries. Some of them, such as Jordan, Pakistan, Panama, Syria, and Turkey, spent between 40 to 90 percent of export earnings on oil imports, and the United States and Japan spent about 31 percent and 32 percent, respectively. Given the more than 100 percent oil price increases in 1979–80, these percentages have increased substantially since then, in most cases. Projections made for 1990 for member countries of the Asian Development Bank indicate that energy imports may account for between 55 and 120 percent of export earnings in low-income countries, and between 17 and 50 percent for the middle-income group, in spite of the fact that the projections also foresee a significant substitution of other energy resources for oil (Sankar and Schramm 1982).

These increased foreign exchange requirements for oil imports were a major contributor to a significant deterioration in the balance of payments of many of the oil importing countries. As a result, their external debt load increased sharply. This is particularly true for developing countries. Since much of their oil expenditure has to be financed through foreign exchange borrowings, rather than increased exports, the accumulation of debt and declining international credit-worthiness of many oil importing developing countries are major unresolved issues. The special problems of the third world are discussed in greater detail later.

World Bank

Domestic Financial Reform Versus Opening up the Capital Account

Figure 2.1 shows that while both reforms of the domestic financial sector and opening up of the financial account of the balance of payments to international capital increased over the past three decades through most regions of the world, there seems to be differences in the pace of these two aspects of liberalization. For example, while the opening up of the domestic financial sector in Emerging Asia proceeded steadily and gradually from the early 1970s to the mid-2000s, much of the opening up of the capital account in this region occurred in the period from 1984 to 1996; prior to and after that period, there was little change in the extent of external financial liberalization in the region. In many countries in Latin America, the period from 1980 to 1987 was marked by the imposition of controls on capital inflows and outflows; there were fewer moves toward greater repression of the domestic financial sector during this period, in contrast. Just as in Emerging East Asia, the late 1980s and the early 1990s was a period of rapid de jure and de facto financial integration in Latin America, as well as in many other regions. To examine whether different sets of factors influence domestic and external financial liberalization, one can disentangle the domestic and external subcomponents of the financial reform index and use them separately as independent variables. The results are reported in Table 2.4.

Table 2.4. Ordered Logit Estimates: Domestic Versus External Financial Liberalization

Notes: The dependent variable is the change in the Financial Liberalization Index, ΔFLit, or one of its two subcomponents: an index of domestic financial reform or of external financial reform. Robust t-statistics are in parentheses, adjusted for clustering by country. Country dummies are included but are not reported. *** denotes significance at the 1% level; ** at the 5% level; and * at the 10% level.

The first apparent difference in the political economy of domestic and external financial reforms is that while initial reforms of the domestic financial system make further reforms more likely, no such dynamic is evident in the liberalization of the capital account. The two reforms are similar, however, in that both are affected by regional diffusion: the greater the distance between the regional reform leader and the country, the more likely it is that a country will reform, regardless of whether the reforms are in the domestic or external sector. This suggests that regional diffusion captures not only competition for international capital – which would only affect the opening of the capital account – but also some demonstration effects of the benefits and costs of domestic financial sector reform.

The effect of crises is more pronounced for domestic financial sector reform than for increased financial integration. While both types of liberalization become more likely following a currency crisis – a somewhat surprising result for external liberalization, given the common perception that capital controls are increased following such crises – banking crises only affect the pace of domestic financial reform. This latter result is to be expected, as the common response to banking crises is to increase government control over the sector, such as through nationalization of troubled banks, possibly to prevent a collapse in confidence. Similarly, domestic liberalization tends to slow or reverse during recessions, but downturns have no significant effect on external financial liberalization.

IMF programs have their effect solely on domestic financial sector reforms – the coefficient on the IMF dummy is positive and significant when domestic financial liberalization is the dependent variable, but the same coefficient is not significant in the capital account liberalization regressions. These results are consistent with other analyses of capital account liberalization, such as Quinn and Toyoda (2007). In their regressions, they find that the IMF program variable coefficient, while positive, never approaches statistical significance. As they note in their paper, “[while] it is widely argued that the International Monetary Fund (IMF) is able, through terms of conditionality in negotiating a program, to impose its policy preferences … the Fund rarely to almost never imposed capital account liberalization on nations as part of program conditionality (p. 346).”

The lure of cheap international capital, on the other hand, as proxied by world interest rates, is mainly associated with opening up of the capital account. The coefficient on the US interest rate variable is positive and highly significant in the capital account liberalization regressions, although it is also occasionally significant in the domestic financial reform regressions. This is to be expected, as competition for international capital is more likely to spur an opening of the capital account.

Economic Impacts

Delivering care to medical tourists will likely increase the level of direct foreign exchange earnings coming into a country and improve the balance of payments position. There are suggestions that Thailand benefits between US$1.5 and 2 billion from medical services and approximately US$0.5 billion from related tourism – overall total value added is 0.4% of gross domestic product. Income from foreign patients can be used within hospitals and national systems to cross-subsidize care for domestic patients, or could be used to help fund capital investment for use by all patients within the hospital or health system. Similarly, there are suggestions that the Cuban experience is to reinvest income from foreign patients into the national system for broader public good. International patients will have multiplier effects – a RAND study of Cleveland's metropolitan economy highlighted the economic benefits that the Cleveland Clinic added to the local economy.

Economic implications vary depending if international patients are simply using spare capacity or competing with domestic patients. For instance, the push by Thailand to be a hub for medical tourists in the 1990s was a result of the economic crisis in Asia generating a fall in domestic private patients and hence spare capacity in their private sector. In this case, increasing foreign patients entailed a net benefit to the private health system with substantial income and little real opportunity cost. However, where capacity has to be developed, there are substantial potential costs not only in financial terms but also in the wider context of concerns around equity, access, and human resources.

Although medical tourism generates income for the health sector (physicians hospitals, medications, and medical devices), general increases in tourist income (airfares, food, hotels, and souvenirs) are also important. There is a substantial level of expenditure by medical tourists, and their companions, that is not related to medical care. For example, it is estimated that companions would spend approximately twice as much on hotels and tourism as the patient. As discussed earlier, the promise of these earnings often drives the government involvement in investing directly or indirectly (tax incentives) in private hospitals and actively promoting medical tourism. Sectors other than medical care – especially those associated with hospitality and travel – may benefit to some degree from increased medical tourism, as will the government more centrally through increased taxation revenue. However, global business models and the involvement of Transnational Corporations may result in profits from medical tourism and ancillary activities being remitted overseas.

In many instances, medical tourists are either Diaspora or patients who have previously visited the country and are likely to visit again (an estimated 2.2% of foreign travelers and 10% of nonresident Indians visited India with the objective of health treatment). Thus, they are ‘regular’ visitors who on one trip incorporate an element of medical care. In this situation clearly the additional income generated by the ‘medical’ element of medical tourism is far more limited.

There are financial costs associated with promoting medical tourism – including upgraded infrastructure, both within the health sector (e.g., hospital facilities) and beyond (roads, airports, and telecommunications). There are also likely to be costs concerned with the appropriate staffing of facilities (including taxpayer's subsidized education and training), and possible accreditation schemes. For instance, 48 countries have been granted accreditation from the US-based JCI, the international arm of the Joint Commission, which accredits US hospitals. India has already sought and obtained JCI accreditation for 17 hospitals, and Thailand for 14. Other international accreditation bodies include the Australian Council for Healthcare Standards, the Canadian Council on Health Services, and QHA Trent Accreditation. However, there are costs associated with ensuring compliance with these various criteria, maintenance of these accreditations, and the processing costs themselves.